Ethics in Brief

Ethics in Brief is designed to present ethical issues that practitioners might well face on a daily basis. It is a service of the Legal Ethics Committee of the San Diego County Bar Association for SDCBA members.

Bankruptcy Proceedings: Do Not Jeopardize Your Entitlement to Fees by Violating Rules

In cases where lawyers violate ethical standards or bankruptcy rules, bankruptcy courts may punish such violations by refusing to approve something very near and dear to bankruptcy attorneys - their fees. 

An attorney that files a chapter 11 case must be approved as counsel for a debtor-in-possession and must also seek approval for his or her fees to be paid over the course of the case.  In making the application to the Court to be employed, an attorney must make a full and complete disclosure of his or her connections with the debtor and other parties-in-interest, must not hold or represent an interest adverse to the estate, and must be “disinterested.” Fed. R. Bankr. P. 2014(a); 11 U.S.C. § 327(a); 11 U.S.C. 101(14)(C). 

Further, the need for professional self-scrutiny and avoidance of conflicts of interest does not end upon appointment.  “[T]he court may deny allowance of compensation for services and reimbursement of expenses of a professional person employed under section 327 . . . if, at any time during such professional person’s employment . . . , such professional person is not a disinterested person, or represents or holds an interest adverse to the interest of the estate . . ..” 11 U.S.C. § 328(c).

The recent case of In re Sundance Self-Storage El Dorado LP, 482 B.R. 613 (Bkrtcy, E.D. Cal. 2012), highlights the impact on attorney employment and payment of fees where an attorney fails to make full and complete disclosures in the initial employment application process and during the course of the attorney’s employment.

Sundance filed a chapter 11 proceeding which was dismissed for failure to file schedules. Counsel was still owed fees from this bankruptcy filing when several months later, he filed a second chapter 11 proceeding for Sundance. Sundance’s principal asset was real property where it operated a self-storage business. Don Smith was the manager of operations of Sundance and was essentially in charge of every facet of the chapter 11administrative process.

About the same time that Sundance filed its second chapter 11 and before counsel filed his application to be employed by Sundance, counsel filed a chapter 13 for Smith so that he could save his home.  Smith was relying upon his salary from Sundance to fund his chapter 13 plan. Smith was also an accountant and had previously given tax advice to counsel and may have prepared at least one business tax return for counsel.

Counsel didn’t disclose that he was counsel in the prior case, was owed money from the first bankruptcy filing, or his connections with Smith when he filed his application to be approved as counsel in the Sundance case.

During the course of the chapter 11 proceeding, the Court granted the Bank relief from stay to foreclose on Sundance’s real property.  Before the foreclosure, Sundance transferred the property to West Coast, a corporation wholly owned by Smith.  West Coast then filed its own chapter 11 proceeding with a different attorney that was referred by counsel. The filing of the West Coast chapter 11 not only stopped the foreclosure, but ensured that Smith would continue to be paid a salary with which to continue to fund his chapter 13 plan. 

The Court learned of the transfer from Sundance to West Coast and issued an OSC requiring counsel to file a declaration detailing his knowledge and involvement regarding the transfer of the real property.  Counsel filed four separate declarations, each in response to the Court’s insistence for further information. Each time counsel revealed a little more about his dealings with Sundance and Smith, but still failed to disclose that he had been and was still representing Smith for the two years that the two bankruptcy cases had been pending. It was the Court that discovered counsel’s representation of Smith.  In his fourth declaration, counsel attempted to explain his connections with Smith (both as Smith’s attorney and possibly as a tax client of Smith’s) to be innocuous circumstances not worthy of disclosure.

However, as the Court noted, it is the bankruptcy court that determines whether a professional’s connections render him or her unemployable under Section 327(a) -- not the other way around. Sundance at 631. The attorney does not get to pick and choose what connections to disclose based on his or her own perceptions of their relevance. Id. at 634.

The Court found that counsel was not a disinterested person for two independent reasons. First, he was a pre-petition creditor of Sundance. Second, by virtue of his simultaneous representation of Smith in Smith’s personal chapter 13 proceeding case and his representation of the debtor-in-possession in the Sundance case, counsel had a direct relationship to and connection with the debtor. This relationship resulted in counsel having “an interest materially adverse to the interest of the estate.” 11 U.S.C.101 (14)(C).  Sundance at 627-628. Counsel both held and represented interests adverse to the Sundance estate which would have precluded his employment from the start if full disclosure had been made at the outset. The Court ordered counsel to disgorge all post-petition fees previously awarded in the present case, as well as pre-petition fees Sundance had paid to him for all work leading up to the case, and even all fees that had been paid to counsel in the first Sundance bankruptcy case.

-- Radmila A. Fulton

**No portion of this summary is intended to constitute legal advice. Be sure to perform independent research and analysis.  Any views expressed are those of the author only and not of the SDCBA or its Legal Ethics Committee.**